Financial Accounting and Accounting Standards

Activity-Based Costing
Activity-Based Management
Dr. Hisham Madi
Activity-Based Costing Systems
 Activity-based costing (ABC) refines a costing
system by identifying individual activities as the
fundamental cost objects.
 An activity is an event, task, or unit of work with a
specified purpose—for example, designing products,
setting up machines, operating machines, and
distributing products.
 ABC systems identify activities in all functions of the
value chain, calculate costs of individual activities,
and assign costs to cost objects such as products and
Activity-Based Costing Systems
 ABC systems identify activities in all functions of the
value chain, calculate costs of individual activities, and
assign costs to cost objects such as products and
Cost Hierarchies
 A cost hierarchy categorizes various activity cost
pools on the basis of the different types of cost
drivers, or cost-allocation bases.
 ABC systems commonly use a cost hierarchy with
four levels—output unit-level costs, batch-level costs,
product-sustaining costs, and facility-sustaining
costs—to identify cost-allocation bases that are cost
drivers of the activity cost pools.
Cost Hierarchies
Output unit-level costs
 are the costs of activities performed on each individual unit of a
product or service.
 These costs increase as the number of units produced increases.
 Machine operations costs (such as the cost of energy, machine
depreciation, and repair) related to the activity of running the
automated molding machines are output unit-level costs.
 They are output unit-level costs because, over time, the cost of
this activity increases with additional units of output produced
(or machine-hours used)
Cost Hierarchies
Batch-level costs
 are the costs of activities related to a group of units of a product
or service rather than each individual unit of product or service.
 Setup machine, shipment setup.
 Indirect setup cost increase with setup hours and number of
Product-sustaining costs (service-sustaining costs)
 are the costs of activities undertaken to support individual
products or services regardless of the number of units or batches
 Design costs are an example of this type of cost.
 Design costs depend largely on the time designers spend on
designing and modifying the product,
Cost Hierarchies
 Product research and development costs, costs of
making engineering changes, and marketing costs to
launch new products.
Cost Hierarchies
Facility-sustaining costs
 are the costs of activities that cannot be traced to individual
products or services but that support the organization as a
 Examples of this type of cost include general administration,
rent, and building security.
 These costs usually lack a cause-and-effect relationship
between the cost and the allocation base.
 This lack of a cause-and-effect relationship causes some
companies not to allocate these costs to products and instead
to deduct them as a separate lump-sum amount from operating
Cost Hierarchies
 Companies may achieve greater accuracy in overhead cost
allocation by recognizing these four different levels of activities
and, from them, developing specific activity cost pools and their
related cost drivers.
 Once a company has classified its activities and identified the
related resources, managers may discover that some
manufacturing overhead costs can be traced directly to products.
 An example of a traceable manufacturing overhead cost at C&C
Sports is the cost of operating the chenille machine. This cost,
includes depreciation and indirect materials, is directly traceable
to the award jackets because the chenille machine is used only to
produce award jackets, and should not be allocated to pants and
Implementing Activity-Based Costing
Step 1:Identify the products that are the chosen cost objects
The cost objects are the 60,000 S3 and the 15,000 CL5 lenses
that Plastim will produce in 2011
Step 2:Identify the direct costs of the products
Step 3: Select the Activities and Cost-Allocation Bases to Use
for Allocating Indirect Costs to the Products
Plastim identifies six activities—(a) design, (b) molding machine
setups, (c) machine operations, (d) shipment setup, (e)
distribution, and (f) administration—for allocating indirect costs
to products.
Implementing Activity-Based Costing
Step 3: Select the Activities and Cost-Allocation Bases to Use for
Allocating Indirect Costs to the Products
Analysis of the activities performed to manufacture a product or
provide a service
The system assigns overhead costs directly to the appropriate
activity cost pool.
For example, rather than define the design activities of product
design, process design, and prototyping as separate activities,
Plastim defines these three activities together as a combined
“design” activity and forms a homogeneous design cost pool.
Implementing Activity-Based Costing
Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation
 Plastim assigns budgeted indirect costs for 2011 to activities,
to the extent possible, on the basis of a cause-and-effect
relationship between the cost-allocation base for an activity
and the cost
 The company must identify the cost drivers for each cost
 The cost driver must accurately measure the actual
consumption of the activity by the various products.
Implementing Activity-Based Costing
 To achieve accurate costing, a high degree of correlation must
exist between the cost driver and the actual consumption of the
overhead costs in the cost pool.
 The strength of the cause-and-effect relationship between the
cost-allocation base and the cost of an activity varies across cost
 For example, the cause-and-effect relationship between direct
manufacturing labor-hours and administration activity costs is
not as strong as the relationship between setup-hours and setup
activity costs.
Implementing Activity-Based Costing
Step 5: Compute the Rate per Unit of Each Cost-Allocation Base
Budgeted Indirect cost rate =
Total Budgeted Indirect Cost
Budgeted quantity of cost allocation base
Step 6: Compute the Indirect Costs Allocated to the Products
Step 7: Compute the Total Cost of the Products by Adding All Direct and
Indirect Costs Assigned to the Products
ABC vs. Simple Costing Schemes
1. ABC systems trace more costs as direct costs;
2. ABC systems create homogeneous cost pools linked
to different activities;
3. For each activity-cost pool, ABC systems seek a costallocation base that has a cause-and-effect relationship
with costs in the cost pool;
4. ABC is generally perceived to produce superior
costing figures due to the use of multiple drivers
across multiple levels
Costs and limitations of an ABC system
ABC can be expensive to use
 The increased cost of identifying multiple activities and applying
numerous cost drivers discourages many companies from using
 Activity cost rates also need to be updated regularly
 As ABC systems get very detailed and more cost pools are
created, more allocations are necessary to calculate activity costs
for each cost pool. This increases the chances of misidentifying
the costs of different activity cost pools.
When to Use ABC
How does a company know when to use ABC?
1.Indirect costs are significant in proportion to direct costs and use
only one or two cost-drivers;
2.Product lines differ greatly in volume and manufacturing
3.Product lines are numerous and diverse, and they require differing
degrees of support services;
4.The manufacturing process or the number of products has changed
significantly—for example, from labor-intensive to capital-intensive
due to automation.
5.Operations staff has substantial disagreement with the reported
costs of manufacturing and marketing products and services
Activity-Based Management
 The process of using activity-based costing information
to manage a business’s activities, and thus its costs.
 is a method of management decision making that uses
activity-based costing information to improve customer
satisfaction and profitability
Activity-Based Management
 A method of management that uses ABC as an integral
part in critical decision-making situations, including:
 Pricing and product-mix decisions
 Cost reduction and process improvement decisions
 Reduce costs by improving the way work is done without
compromising customer service or the actual or perceived
value (usefulness) customers obtain from the product or
 Eliminate activities that consume resources but do not
contribute to the value of the product non value added.
Activity-Based Management
 Design decisions
 Identifying new designs to reduce costs.
 Planning and managing activities
ABC and Service/Merchandising Firms
 The overall objective of ABC in service firms is no different than
it is in a manufacturing company
 That objective is to identify the key activities that generate costs
and to keep track of how many of those activities are performed
for each service provided
Health Care